A look at investment company charges

David Prosser takes a look at fund charges in both the closed and open ended collectives universe.

What do your fund investments cost? This isn’t the first question that most people consider when thinking about how to invest for the future – but while their instinct is naturally enough to focus on the returns that a particular fund might generate, performance and charges are inextricably linked.

This is logical. Every penny of your money that a fund manager takes out of your investment in charges is a penny on which you are not earning returns. Moreover, in the longer-term, the effect of compound interest means that even relatively small charges – or differences in charges – can have a dramatic effect on returns.

Investment companies’ historical advantage

In the past, this has been an area where investment companies have held a substantial advantage. In general, closed-ended funds have been significantly cheaper than their open-ended equivalents. In turn, this has been a very important factor in the explanation of why, on average, investment companies have tended to produce better medium- and long-term returns than open-ended funds – even in cases where two comparable funds, one from each sector, are run by the same manager.

At the beginning of 2013, however, regulatory reform paved the way for closed-ended funds’ advantage on cost to be eroded. The retail distribution review outlawed the payment of commission to financial advisers by product providers. Investment companies have never been able to offer commissions to intermediaries, so weren’t directly affected, but open-ended funds were prolific payers to advisers – and now they are no longer able to make these payments, they have been able to cut their charges.

The result is that fees in the open-ended fund sector have tumbled. Many open-ended fund managers have even introduced new ‘clean’ classes of share, in order to emphasise the new low-cost nature of their products.

A closed-ended fight-back

All other things being equal, this could mean that one of the investment company sector’s most important advantages is no longer relevant. If closed-ended funds are no longer able to offer much lower charges than their open-ended equivalents, will their record of outperformance falter?

Well, the first point to make is that the closed-end sector doesn’t operate in a vacuum – investment company boards have noted the lower charges now being levied in the open-ended sector and responded accordingly. Dozens of funds have cut their own annual management fees over the past 18 months, with new reductions still being announced every week.

We have also seen investment companies move to simplify their fee structures. Many funds in the closed-ended sector charge performance fees – these are only payable if the fund hits set performance criteria. But while these fees incentivise managers to perform better, they can be complicated – and they also make it difficult to compare charges with those of other funds. Accordingly, many investment companies are now simplifying, reducing or simply abolishing performance-related charges.

The other point to make here is that, while charges have been an important factor in closed-ended funds’ outperformance, there are other reasons why investment companies have done better. Their structure, their ability to take on gearing, and their greater flexibility, for example, have also been important.